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In this discussion, we will examining the concept often referred to by financial journalists as the 'business cycle'. The basic business cycle is an overall term referring the broader ebb and flow of the economy over time. The business cycle, also referred to as the economic cycle, maps the general changes of the health in the economy over defined time periods. These periods include times of rapid economic growth, which we are currently experiencing and times when the economy is contracting.
 There are four basic periods in the business cycle. They are:
- peak,
- contraction,
- trough and
- expansion.
The time frame for each period will vary depending upon underlying market fundamentals in conjunction with other intangible variables, like consumer sentiment. As such, no two time periods are the same. It follows that the last business cycle will not last as long as the previous cycle and neither will the current business cycle last as long as the next one.
The rise and fall of a each period within the business cycle is generally measured by the use of Gross Domestic Product (GDP). GDP is basically a summary statistic of the market value added in the production process or goods and services. The reasons for changes in GDP could include factors external to the economy, such as the weather and international demand or internal to the economy, which include things such as fiscal and monetary policy, interest rates, regulatory policies and inflation.
As detailed graphically above, the four periods of the business cycle are obvious. The peak is the upper turning point of the economy. This occurs when the economy is at the zenith of strong GDP growth. As the economy softens and the GDB weakens, economic contraction is evident. If the contraction becomes severe it can translate into a recession or in its extreme, a depression. The depth of the trough will indicate the severity of the economic contraction. In a reverse mirror image of the peak of the economic cycle, the trough is the lower turning point of the business cycle heralding economic expansion. Finally, the expansion phase occurs after the trough and is signalled by the speed up of economic activity.
The aforementioned discussion is the basic business cycle. There are many different types of cycles that economists have written about and debated. Some of these include the
- Kitchen inventory cycle, which lasts from between 3 to 5 years,
- Juglar fixed investment cycle (7- 11 years),
- Kuznets infrastructural investment cycle (15-25 years) and finally the
- Kondratieff wave which last from between 45 to 60 years. That is almost a whole lifetime!
The above cycles are only the tip of the iceberg and are best probably left to the academics. The basic business cycle is the arguably the most important information long-term investors need to know.
Why is understanding the business cycle important to long-term investors?
Long-term investors with an appreciation of where the Australian economy is in terms of the business cycle can yield higher returns.
For instance, if the economy is at the peak, then it's time to get out of the consumer discretionary sector and into infrastructure stocks. The reason for this is that infrastructure stocks are considered defensive and consumer discretionary are sensitive to the economic cycle. Alternatively you might consider holding more cash during this peak phase of the business cycle. Conversely, if the business cycle is at the trough then moving into consumer discretionary stock is ideal.
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